The Savings and Loan Crisis, The RTC, and the Paulson Plan

(There has been a recent discussion regarding the Paulson Plan with a great number of individuals comparing it to the Resolution Trust Corporation (RTC) that was created after the savings and loan crisis. The purpose of this post is to explain the S&L crisis and then (very) briefly contrast the RTC with the Paulson Plan. The information on the S&L crisis comes from my lecture notes for Money and Banking. The main resource used in putting together these notes is Frederic Mishkin’s Economics of Money, Banking, and Financial Markets. Any errors are my own.)

Before the 1980s, federal deposit insurance seemed to work exceedingly well. Bank failures between the creation of the FDIC and 1980 were very rare. This changed greatly after 1981.

Early Stages

Financial innovations, as we have previously discussed, severely cut into the bottom line of the traditional banking business. Commercial banks were losing money to instruments like money market mutual funds.

As profitability fell, banks were forced to undertake new activities. These activities tended to be very risky, including the failure to diversify loans and purchase of financial futures and junk bonds. Further, the fact that the government stood to provide insurance in the wake of a failure provided little incentives for banks or their customers to fully take account of the risk involved in these new activities.

The following set the stage for the problem:

• Deregulation gave more power to S&Ls beyond home mortgages.

• This deregulation was coupled with an increase in the mandated amount of deposit insurance (from $40,000 to $100,000).

• Deregulation also phased out Regulation Q, which had placed ceilings on interest rates.

• S&Ls began engaging in new activities in which many managers were not qualified.

• There was rapid growth in new lending, especially in real estate.

• The quest for profitability began to cause banks to ”specialize” in loans to certain industries.

The consequences:

• Increases in inflation and contractionary monetary policy put upward pressure on interest rates leading to rising costs that were not matched by higher earnings because most mortgages were issued at lower, fixed rates.

• A recession in 1981-1982 caused a collapse in the prices of energy and farm products which led to significant defaults on loans among S&Ls.

• HUGE collapse of S&L industry with more than have with negative net worth (insolvency) by the end of 1982. Losses were estimated at about $10 billion.

Later Stages

Exacerbating the problem:

• Regulatory agencies lacked the funds to close the S&Ls and pay their depositors.

• Regulators used regulatory forbearance. In other words, they failed to exercise their regulatory powers.

• Savings and Loans began to take a great deal of risk to grow out of insolvency.

• The results were disastrous. Insolvent institutions were unknown to the general public and the insolvent firms were competing alongside the solvent. This forced solvent firms to pay higher rates of interest in trying to compete with the insolvent firms who were desperate for funds to make risky bets. This squeezed the lifeblood from the solvent banks and even dragged some of them into insolvency.

Competitive Equality in Banking Act of 1987

The CEBA gave financing to the regulatory agency of the S&Ls, but the funding was not sufficient and was even below the requested amount by President Reagan (which was also probably a low balled number to begin with – $15 billion). Further, regulatory forbearance continued at the behest of Congress. The losses continued throughout the 1980s.

Upon taking office in 1989, President George H.W. Bush proposed new legislation to provide the adequate funding to close the insolvent S&Ls. The FIRREA did the following:

• Eliminated the former regulatory structure that was in place and gave this power to the Office of Thrift Supervision.

• Further, the S&L insurance system was eliminated and the FDIC overtook these powers.

• Finally, the Resolution Trust Corporation (RTC) was created to sell off the real estate assets of the insolvent thrift firms. The RTC was able to sell 95% of the assets of the insolvent firms, with a recovery rate exceeding 85%. Afterwards, the RTC went out of business in 1995.

• The bailout cost $150 billion.

Federal Deposit Insurance Corporation Improvement Act of1991

The FDICIA followed from the FIRREA and was passed for two reasons:

• To recapitalize the FDIC’s Bank Insurance Fund.

• Reform deposit insurance and regulatory system to minimize taxpayer losses in the future. To minimize moral hazard, the FDIC must now close failed banks using the least costly method. This creates the likelihood that uninsured depositor losses will occur. A provision exists, however, in that if two-thirds of the Governors of the Federal Reserve and the directors of the FDIC deem an institution ”too big to fail” and is approved by the Treasury Secretary, all depositors will be protected. This should only be done when the failure to do so would result in significant economic losses.

In addition, the FDICIA created a ranking of banks by the level of capitalization. Banks in the lowest group are prevented from paying above average interest rates on deposits and can even be closed by the FDIC if the amount of equity capital falls below a certain percentage of assets (2%).

The Paulson Plan Versus the RTC

The preceding analysis hopefully provides enough background to discuss the Paulson Plan in contrast to the RTC. Under the Paulson Plan, the government would be purchasing assets with uncertain value from currently operating institutions. This is a direct contrast to the RTC in which the government was selling the assets of failed institutions. The Paulson Plan raises many important questions. Uncertainty is the primary reason that firms cannot estimate the value of their assets. Given this uncertainty, counter-parties are unwilling to purchase such assets because of the fear that they might overpay. How precisely will the government entity created under the Paulson Plan value these assets when those in the industry do not? Further, what incentive does the entity have to ensure that they are purchasing the assets at a favorable price?

The lack of oversight and incentives suggests that the Paulson Plan is one that is likely to overpay for assets that few, if any, are able to accurately price under current conditions. This represents a significant bailout for Wall Street at the expense of taxpayers, which is neither warranted nor acceptable. Whether or not any such bailout would put an end to the crisis is debatable. However, what is not debatable is the dangerous precedent that such action would set. I urge my fellow economists, and fellow taxpayers, to reject such a plan.

8 responses to “The Savings and Loan Crisis, The RTC, and the Paulson Plan”

I’m not a cheerleader for this plan by any means, but I think the thing missing from you analysis is time. This paper is priced at panic values and many suspect it is a better bet than mark-to-market indicates.

The gub’mint is in a somewhat unique position to hold this through the panic. Much will be bad, but a lot will be good and will mature or return to a much greater value than current price.

To respond to one of the comments, if time is an issue it seems to me that it may actually support an argument FOR using FDICIA rather than designing a new plan. Isn’t it the deal-stopper for now that the lawmakers just cannot get their head around the problem, not to mention understanding the importance and impact of the proposed solution?

My first impression is that people in Washington would be much comfortable to use something carved by someone else in the past and thus share the responsibility with the lawmakers who designed FDICIA. So I believe the question is not the time but whether the Paulson Plan can deal with the problem better than triggering the provisions proposed by FDICIA.

Excellent summary. Thanks. One area I’d like more information on is the initial and final cost to the taxpayer for the S&L bailout. Im hearing many people ranting on how the government made money from the S&L crisis yet I will not believe this myself until I see proof in the numbers – well analyzed numbers, and not hokey pokey numbers. I’d love to see a continuation of your story above that tackles the cost issue in more detail.

We need to come up with a more innovative plan to sell these real estate assets. The current situation is not working as banks have too many properties to sell and give all of the listings to a few, overworked agents. This is bad business. Also, the banks need a much better way of handling the backlog of short sales which are deflating the market values in many areas.

The problem now is that purchasing existing notes from the FDIC is more attractive for investors than providing money for new ones. As long as the FDIC is willing to sell notes at pennies on the dollar, no money will appear in the secondary market and no new loans will be given by banks. Where is the commentary on this?

I find it amazing in such obvious scrutiny- that you aren’t even once pointing out the timing of all this. Your first date of trouble is 1981- the Reagan revolution. Then you describe very well the influx of mutual funds – yet not a word of the ethics of such “ponzi” type of institutions and the fact that all this made the entire American Banking system profoundly more prone for foreign exploitation and fraud. You never – as I recall- mention the name “Bush” who had a profound and unchecked conflict of interest with sons on bank boards giving huge loans to business partners while their father was Vice President and then President of the nation. The fact that you had Mr Clinton come in and no investigation whatsoever- thus letting all possible criminal legal discovery null and moot. Meanwhile- the nation of China seems to have benefitted of this “Crisis”- a very man made and deliberate one indeed! Now the Paulson $700 billion plan is the throwing of tax payer money at the exact same type of debacle – with many of the same names. If you even entertained the notion that this is a prolonged attack upon or nation and doctrine through these “Quasi Fascist Beijing Financial Trojan Horses- I would think you were performing a valuable public service- but without these inconvenient and yet obvious malfeasance by the highest officials in our government? It tends to desensitize the reader from the obvious criminal heist and conflict.